The HUB NEWS AND VIEWS FOR INSTITUTIONAL INVESTORS Find out more: im.natixis.com/en-institutional Value investing – Is it different this time? A value investor usually requires a substantial price discount at the company’s intrinsic value. But the latter exceeds the mere accounting value of its tangible assets. During the internet bubble in the late Key Takeaways: 1990s, it was common to hear other investors say, “It’s different this time,” • The core principles of Value as justification for their investments Investing have been defined by in internet stocks. They claimed the old rules of valuation no longer Ben Graham and David Dodd applied to the internet economy. in their book “Security Analysis” in 1934. Graham’s idea of a The pace of technological innovation Daniel Nicholas “margin of safety” translates was so rapid that the next Client Portfolio Manager to purchasing a stock if and technology was thought to be just Harris Associates only if it is priced at a sufficient around the corner, quickly making discount to the company’s the current technology obsolete and, that they trade on average at 34 times intrinsic value. thus, the created assets not durable. For the internet stocks, cash flowed next 12-months GAAP (Generally Accepted Accounting Principles) • The precise understanding of mainly out of the business and earnings were promised, but in the earnings. After 10 years of value what the company’s intrinsic distant future. The stock market had indexes underperforming growth, are value is has been challenged a preference for explosive growth value managers who own FAANGs again and again over time. With and a corresponding indifference drifting away from their value roots? the emergence of FAANGs over to valuation. Or could it be different this time? the last 20 years, the notion Birth of value investing has become more and more To start 1999, the 10 largest stocks Let’s go back to the start of value prominent that a large part of a accounted for 21% of the S&P 500 investing to determine what, if Index and included Microsoft, Intel, company’s intrinsic valuation is anything, has changed. In 1934, IBM and Cisco Systems. After the intangible and cannot be found Ben Graham and David Dodd wrote Vanguard Growth Index returned over Security Analysis, which was quickly on a balance sheet. 27 points above its Value Stock Index adopted as the Bible of value in 1998, these 10 stocks entered 1999 investing. In it, Graham explained • Between Warren Buffet, student trading at a 44 times price-earnings his idea of only investing when he of Graham, and the burst of the (P/E) ratio. In the end, we know how had a “margin of safety,” meaning he DotCom bubble, the question the story played out. Value was not purchased a stock when it was priced persists: How does one dead and the vilified value investors at a large discount to a company’s establish the margin of safety were vindicated. intrinsic value. The concept remains a core principle of value investing today for the potential of a company to Twenty years later, though, some of even though the idea is almost 100 generate value? today’s high-flying stocks, including the FAANGs (i.e., Facebook, Amazon, years old. Apple, Netflix and Google) are Back in the 1930s, influenced by just drawing comparison to the internet having been through a depression, bubble. FAANGs are actually making it a company’s intrinsic value was into value portfolios, despite the fact defined as its liquidation value. MARKET INSIGHTS DOCUMENT INTENDED EXCLUSIVELY FOR PROFESSIONAL CLIENTS (IN ACCORDANCE WITH MIFID) 1 The HUB NEWS AND VIEWS FOR INSTITUTIONAL INVESTORS Therefore, Graham proposed the By citing the decreasing importance Over this time period, we have owned following formula: A stock passed his of tangible assets in determining several packaged food companies margin-of-safety test only if it sold business value, this quote sounds as when we thought increased brand for a large discount to this estimated timely now as when it appeared in advertising understated earnings. We liquidation value. Berkshire’s 1983 Annual Report. What have owned cable TV distributors Buffett figured out earlier than most that reported net losses and negative The next 40 years value investors was that conservative book value while rapidly increasing Over the next 40 years, stock prices accounting rules overlooked the their subscribers. And we have owned were generally quite tightly tied value of intangible assets (e.g., brand high-growth biotech companies to their book values and patient names, customer lists, R&D spending that sold at lower P/Es than mature investors could often find companies and patents). In turn, book value didn’t pharmaceutical companies once we that were out of favor, trading fully reflect the economic value of treated their R&D expenditures as below estimated liquidation value. businesses with strong brands. long-term investments. We believe The asset-heavy economy made In today’s asset-light economy, today’s earnings and P/E ratio is a it appropriate to value businesses intangibles have become more very poor indicator of the true value based on their tangible assets. In fact, important. The relative significance of FAANGs, so we apply different as recently as 1975, 83% of the stock of tangibles compared to intangibles statistics that best capture each market value of the average company has completely flip-flopped from company’s unique intrinsic value. As was represented by its tangible what it was 40 years ago. They now intangibles have grown in importance, book value. account for over 80% of the average the thought process is no different However, in an economy where value company’s market value. Much like than what led us to own food and was derived from fixed assets, it Graham, however, GAAP doesn’t even cable stocks early in the 1980s. Today, was hard to maintain a competitive attempt to value those assets. it simply applies to more companies. edge. If you earned unusually high For example, for companies in Finding value investors returns, others would duplicate your the S&P 500 today, the correlation fixed assets and your advantage In a world where business value between stock price and tangible disappeared. That made it difficult rests primarily on intangible assets, book value has become quite for companies temporarily trading it’s also harder to use a style box to small, just 14%. This is a very big at large premiums to book value to understand a portfolio manager’s change from 25 years ago when that sustain their high stock prices. So an investment approach. Though our correlation was 71%—or five times effective investment approach was to portfolios still typically have a lower stronger than it is now. Unlike then, buy the stocks priced at discounts to P/E than the market, we are more knowing the book value of a company book value and then patiently wait for frequently investing in “exceptions” gives little clue as to its stock price. reversion to the mean. where the GAAP P/E looks Valuing businesses in 2019 expensive. For those “exceptions,” 1980s to present true value investors should be able With this change in the global By the early 1980s, the Berkshire to explain how they calculate their economy, the technique for finding Hathaway investment portfolio, margin of safety: What are they margin of safety has changed. managed by Warren Buffett, looked getting that they don’t think they’re Authors Feng Gu and Baruch Lev nothing like the low price-to-book paying for? believe it’s time for investors to investments favored by his teacher change their investment model¹. For example, we currently have a Graham. The portfolio included Put simply, they believe forecasting holding in Alphabet, despite the fact General Foods, RJ Reynolds, Time Inc. earnings has lost relevance and even that it trades at 22 times reported and Washington Post Co. When asked a perfect prediction of corporate next 12-month earnings and is about the apparently high prices he earnings no longer yields substan tial owned by many growth managers. paid for those companies relative to gains for investors. They advocate To determine the company’s intrinsic their book value, Buffett was fond for “changing the focus of security value, we use a sum-of-the-parts of saying that their most valuable analysis and valuation from earnings approach. Alphabet has more than assets—their brand names—were to a broader, long-term competitive just Google, the world’s leading not even on their balance sheets. At analysis, based primarily on search engine. To find the valuation of the time, he was quoted saying, “My non-GAAP data.” all non-Google assets, we value cash, own thinking has changed drastically cumulative investments in venture from 35 years ago when I was taught We agree with this “new” approach capital-like projects (they own Waymo, to favor tangible assets and to shun since we have been doing so for the leader in autonomous driving businesses whose value depended more than 40 years. We seek out technology) and YouTube. Together, largely on economic goodwill.”. investments whose economic value these investments contribute nothing is not easily seen in the simple GAAP to Google’s current earnings, despite metrics of net income and book value. having tremendous value. These MARKET INSIGHTS DOCUMENT INTENDED EXCLUSIVELY FOR PROFESSIONAL CLIENTS (IN ACCORDANCE WITH MIFID) 2 The HUB NEWS AND VIEWS FOR INSTITUTIONAL INVESTORS investments are what we’re getting In summary for free, which creates our margin - Inv estors follow fads, get emotional So, in fact, it isn’t different this of safety in investing in Alphabet.